Most people are familiar with the charitable activities of private foundations bearing the names of giants of U.S. business—the Rockefeller, MacArthur, and Bill and Melinda Gates Foundations, to name just a few. These foundations still play a vital role in charitable activities around the world, but the wealthy are increasingly directing their charitable contributions to donor-advised funds. DAFs now significantly outnumber private foundations in the U.S., and the gap is widening.

What is a Private Foundation?

Private foundations are separate legal entities from their founders, created exclusively to perform charitable work. Whereas a public charity must solicit contributions from external sources in order to sustain its work, a private foundation is sustained by the contributions of its founders. The principal donor maintains complete control, defining the foundation’s mission, the membership of its board of directors, its investment strategies, and its criteria for awarding grants, and this control is passed on to the donor’s heirs.

What is a Donor-Advised Fund (DAF)?

A donor-advised fund is usually established under the umbrella of a public charity, in cooperation with investment firms who make the DAF available to their clients. In contrast to private foundations, a single donor does not usually have exclusive control over the fund’s investment strategies and charitable activities. Yet as the phrase “donor-advised” suggests, all major contributors have significant power to shape how their donations are put to use.

What Are the Advantages of a DAF Over a Private Foundation?

The reasons for the rapid growth of DAFs as a preferred vehicle for charitable giving among the wealthy can be roughly divided into three categories: tax benefits, flexibility, and privacy.

DAFs offer greater tax benefits than private foundations

Contributors to DAFs can deduct a higher percentage of their gross incomes for their donations than those who donate to a private foundation. DAF donors can also deduct the fair market value (FMV) of any closely held investments such as stock or real estate, whereas private foundation donors may only deduct their cost basis for such investments. Furthermore, investment income earned by a private foundation is taxed (though at a very low rate). As long as the money stays in the fund, a DAF earns investment income tax-free.

In addition to tax savings, a DAF can offer greater tax management simplicity. DAFs are easier and less expensive to launch than private foundations, do not require a lengthy IRS approval process, and often include built-in support to handle all tax compliance matters, including return filing, budget oversight, and more.

DAF donors have the flexibility to determine when and where the money is used

By law, a private foundation must pay out a certain percentage of its assets in grants each year (the Annual Distribution Requirement). This requirement can potentially impede the foundation’s pursuit of its mission, since some years present fewer opportunities than others to put the foundation’s resources to best use.

Because DAFs do not have an annual distribution requirement, contributors can instruct fund managers to hold their donations in the fund until opportunities arise to make grants that will have the greatest impact. The donor is thus free to make contributions whenever doing so offers the greatest tax benefit, without worry that the money will be disbursed ineffectually to meet annual quotas.

That headline has an ironic ring, but it is true. A private foundation must publicly disclose all of its charitable activities, and since the foundation is tied so closely to one family or business entity, the philanthropic priorities of the founders are laid bare for all to see. Although DAF-issued grants are matters of public record, there is no requirement to disclose the identities of fund contributors. This privacy protection is often the decisive factor in a wealthy donor’s selection of a DAF over a private foundation.

Advantages of Having Both a DAF and a Private Foundation

When weighing the merits of DAFs and private foundations, bear in mind that an all-or-nothing decision is not necessary. Many philanthropists simultaneously invest in DAFs and operate their own foundations. Because getting started with a DAF is relatively simple and inexpensive, donors can begin by making small grants from their private foundations to a suitable DAF as a way to test the waters. Some even put their heirs in charge of tracking the DAF and advising the fund manager so they can gain experience managing charitable activities before assuming the reins of the family’s foundation.

Conclusion: Practicality, Control, and Legacy

While the practical advantages of DAFs are numerous, private foundations still offer unique opportunities for complete control and establishment of an enduring family legacy. Philanthropists and wealth managers have begun discover ways to experience the best of both worlds.